Sovereign borrowing from powerful banks is centuries old. Venice was the Wall Street of the early Renaissance. The banks located in the watery grandeur there loaned money to faraway kings and traders. Kings didn’t regulate banks but they did often force repayment by raising an army.

Our government reaches far beyond the actions of kings, who merely wanted their money back, and attempts to regulate banks. The government borrows and it oversees. It’s a big effort as the new financial reform law, Dodd-Frank, more strictly regulates the capital adequacy of banks and enforces “fair dealing” and transparency. Reining in the practices of banks and securities firms is hard work but it’s vital to protect our public institutions, taxpayers and investors. Well regulated banks and the rule of law cancels the need for armies to be raised to have a functional financial system.

Cities and states use banks to raise money to build schools and sewer systems. This is primarily done through the municipal bond market which is becoming a well regulated area of the financial system.

Increasingly, though, public entities are borrowing directly from the banks in lieu of issuing bonds. New Jersey and California recently took out multi-billion dollar loans from banks instead of using the debt markets. This illustrates how powerful the banks are that they are big enough to lend to state as big as California. The problem is that this is done in the dark with no requirement for disclosure or fair dealing by the banks. The practice of direct lending by banks is running ahead of the law. And it poses two problems.

The first problem is that banks and securities firms do not have the same standards for “fiduciary” care imposed upon them by the law when they organize “bank loans”. The rules in this market, set forth by the MSRB, have historically related to publicly issued “municipal securities” not privately organized bank loans.

Sensing a growing problem the MSRB put out an announcement today warning banks that although this area is murky they intend to rigorously enforce the rules they have and require banks to meet the higher standards of care imposed by issuing bonds in the public markets. I won’t glaze your eyes with the arcana of the MSRB’s methods but they are acting strongly to oversee this activity of the banks. They are running hard to stay abreast of the practices of the banks.

The second problem is when banks lend directly to states and cities no one outside of the government knows about this activity unless officials announce it and include it in the public accounting of the state’s liabilities. There are no disclosure rules for direct bank borrowing similar to the ones that exist in the municipal securities markets. Notice of the borrowing would likely not show up until the next year when the annual report is filed.

California is an example of bank borrowing not showing up in the public financial information. California provides this chart of the state’s summary of annual debt service but doesn’t show the short term borrowing from the recent loan which adds another $5.4 billion to their liabilities.

The government, having learned from the financial crisis, is working hard to protect public entities and investors. The area of bank loans to states and cities is the latest area requiring new rules and scrutiny. Banks and securities firms need rules that are rigorously enforced. It builds a stable system and resolves potential problems within the rule of law.